Here’s the dilemma for business owners: the business is growing and you’d like to invest some of the profits back into it.
But, you’ve been working long hours and need to earn money.
Where’s the balance? As a business owner, how should you pay yourself? And how much?
How do Small Business Owners Pay Themselves?
Small owners have choices in how they pay themselves. The choices are tied into the business structure and company earnings. There are certain tax advantages with the various business structures.
For example, if you’re a sole proprietor of a business, you can take an owners draw. The draw is money you pull from equity in the business – money that you’ve previously invested into the business.
If your business structure is a partnership the partners can draw a salary or receive distributions. Or each can do an owners draw.
If your business is a corporation, you can receive dividends as corporate shareholders.
Each method of payment includes its own specifics of how to pay taxes on the money.
How to Decide How to Pay Yourself as a Business Owner
Research the pros and cons, and tax implications, of each choice of specific business structure.
Business Entity
If your business is a sole proprietorship, such as when you pay yourself as a freelancer, you can deduct expenses. You can also deduct the amount of your draw, or draws – the money you pay yourself back from your investment into the company. This money is not taxed when you do the draw, and it can be deducted as an expense.
If you’re a single member LLC (limited liability company) you can also do a draw. The advantage is that as an LLC, your personal assets such as a home and vehicle, are protected .
If you’re a partnership, which is two or more owners, you are personally liable for business debts. Income in the form of draws or salaries can be tied into the percentage of money each partner has invested. That would be spelled out in the partnership agreement. For example, if there are 3 partners and one put in 50%, and the other two each put in 25%, on a $10000 draw one partner gets $5000 and each of the other gets $2500.
If you’re a corporation (c corporation), the corporation will be taxed as a separate entity. The owner and shareholders may get dividends.
Taxation
Income from a sole proprietorship, a single member LLC or a multi member llc is typically reported on Schedule C as Profit or Loss from Business. You’ll be taxed on that on your personal tax returns according to your tax bracket.
You’ll also pay self employment tax as part of your tax bill, which is a tax to fund Social Security and Medicare.
A corporation is taxed as its own entity. You’ll be taxed on dividend income on an IRS 1040 form.
Owners Equity
Owners equity is how much has been invested into the company. It can include the startup monies that were used to purchase real estate and equipment.
In a business plan, owners make a projection for how they hope the business will grow. Many owners have a plan that may include putting a certain percentage of profit back into the business.
However unprecedented challenges such as the pandemic can make those projections unrealistic.
How much to pay yourself then? You have to earn a living wage from your own business. Who else is going to keep the business going? There may be times when business entities must pull out owner’s equity to cover personal expenses.
Small Business Salary
A salary can be based on revenue or can be a set amount in a guaranteed payment. That can be easily tracked through the separate business account. Paying yourself can be as simple as transferring money from the business to the personal bank account. But you have to be careful because you don’t want to be using a business account for personal use.
A reasonable salary would be a moving target based on how much revenue is being generated. It can be a percentage of revenue. A salary can be paid on a structured schedule, such as bi-weekly or monthly.
What are the Pros of Paying Myself with a Salary?
- You’ll have a regular payment to count on.
- You can elect to be paid on a percentage of profits, which will provide incentive to keep the business performance growing.
- If you’re engaged in running the company, and an owner, the IRS expects you to pay yourself a salary.
What are the Cons of Paying Myself with a Salary?
- If you have a standard salary amount regardless of profit, you run the risk of making the business unstable as it grows, if profits aren’t as great as projected.
- You’ll be taxed on it as income when you pay income taxes.
Owner’s Draw
What are the Pros of Paying Myself with an Owner’s Draw?
- The amount of a draw is deducted from profits as an expense, which will reduce the overall company’s profits amount (lowering taxes).
- You’ll be getting back the money you put into the company.
- You are only taking back what was put into the company, and additional profits can be reinvested.
What are the Cons of Paying Myself with an Owner’s Draw?
- Pulling out money using owner’s draw reduces the business capital.
- The rules on draws from llcs vary greatly from state to state. You may need tax advice before your set up draws from an llc.
What Mistakes Should I Avoid when Paying Myself as a Small Business Owner?
- You must have a separate business bank account.
- For personal income tax, you should pay estimated taxes on a quarterly basis.
- You should decide on a payment method before choosing your best setup for a business entity.
- You should have a payment schedule based on what your state Department of Labor requires. Although you’re paying yourself, you’ll have to abide by standards your state sets for payments, either weekly, biweekly or monthly.
- You need a rainy day amount to keep on hand for unexpected operational expenses, based on your financial statements and any guaranteed payments.
- Set aside money to pay and file taxes at the end of the year.
How much should you pay yourself as a business owner?
To determine reasonable compensation, many business owners use these figures as a basis for calculations: basic expenses, business’s performance/ profit, business plan for growth, your personal needs.
What is the best way to pay yourself as a business owner of an LLC?
Sole proprietors can use an owner’s equity formula: The amount the only owner invested, plus profits; less outstanding money owed and draw.
What Types of Tax Will I Need to Pay for a Small Business?
- Personal tax return based on business profits.
- Self employment taxes
- Payroll tax
- Business taxes – Federal income tax, social security and medicare taxes, Federal unemployment tax.
- Excise tax – If you manufacture and sell certain products.
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